Organization Theory and the Theory of the Firm

1. Organization Theory and the Theory of the Firm The following summary is based on two chapters in the Handbook of Industrial Organization: • Chapter 2 on The Theory of the Firm • Chapter 3 on Transaction Cost Economics As the chapters were published in 1989, a great deal of recent research is not included However, key issues and open questions remain substantially the same

2. Main Issues • Behavior and organization within the firm is poorly understood relative to interactions between firms in markets; the lack of data probably accounts for much of this gap • Even though applied research in this area is difficult, it is important to be aware of the main issues because they have implications for work in other areas • For example, firm behavior is the result of a complex joint decision process within a network of agency relationships – employees are not owners • If agency problems are sufficiently severe, the firms in question may not maximize their value

3. 1. Limits of Integration • What determines the scale and scope of a firm? • Perhaps surprisingly, we do not have very good answers to this question • It is difficult to specify measurable tradeoffs between the benefits and costs of integration • Firms form, so some integration is optimal, but all transactions are not organized in a single firm, so there must be costs to increasing size • Williamson (1975, 1985) poses the problem as one of selective intervention: why not combine all firms into one and intervene in their operations only when doing so is profitable?

4. Firm Size • Microeconomics texts refer to long run average costs curves that eventually slope up • What are the sources of diminishing returns to scale? • Lucas (1978) focuses on scarce managerial inputs • Geanakopolos and Milgrom (1985) refer to the benefits of coordination balanced against the costs of communication and information acquisition • Lucas (1967) focuses on adjustment costs that limit firm growth; Jovanovic (1982) emphasizes imperfect knowledge about ability that limits growth – these perspectives do not impose caps on size per se

5. Incomplete Contracts • The technological models do not really address the selective intervention problem • A more productive approach considers problems with contracting that prevent selective intervention • Williamson (1975, 1985) emphasizes that contracts are incomplete • In reality, it is essentially impossible to use a contract to describe appropriate behavior in every contingency for every party • This has implications for organization: when irreversible investments are required, contractual incompleteness can lead to hold up, which favors integration

6. Incomplete Contracts and Investment • Grossman and Hart (1986) establish that when contracts are incomplete, the allocation of residual control rights (rights not specified in the contract) becomes critical • If residual control rights over a particular asset are allocated to the owner of that asset, then ownership determines the ex post division of surplus in cases not covered by the contract • Thus, the ex post division of surplus depends on ownership • This implies that ownership can affect the incentives for ex ante investments; integration or non-integration may be optimal depending on which yields better incentives for investment

7. Information Flows and Incomplete Contracts • Williamson (1985) asserts that organizational changes imply changes in information flows • Certain information that is available at one cost before integration may not be available at the same cost after integration (Filson and Morales assume this) • If true, organization design definitely influences performance, because information is used in decision making and incentive provision • Grossman and Hart (1986) disagree with this view and assume that integration/non-integration affects only residual control rights

8. Influence Costs • Milgrom (1988) emphasizes that integration results in costly influence activities, which are essentially rent seeking activities undertaken by employees within the firm • Non-market organizations are susceptible to influence costs because they have an authority structure that can affect resource allocation and because there are quasi rents associated with jobs within the hierarchy • Bureaucratic inflexibility may be a rational response of firms to limit the extent of influence activities

9. Relation to Empirical Work on Firm Size • The authors, Holmstrom and Tirole, claim that the incomplete contracts paradigm and its associated issues (incentives, information flows, influence costs) is that only one that resolves the selective intervention problem • However, there is a need to tie these perspectives to empirical work on the firm size distribution and firm growth • It remains to be seen whether precise relationships can be drawn between these frameworks and observable firm size

10. 2. Capital Structure • Modigliani and Miller (1958, 1963) established that capital structure is irrelevant: the value of a firm in a frictionless and tax-free capital market is independent of the mix of equity and debt and changes in dividend policy • The reasoning is straightforward: • If the value could be changed by altering the financial mix, there would be a pure arbitrage opportunity • An entrepreneur could purchase the firm, repackage the same return stream to capitalize on the higher value and yet assure the same risk by arranging privately an identically leveraged position

11. Early extensions • Intuitively, MM cannot be the final word on this subject • Real world firms invest considerable effort in determining their financial structure • Social bankruptcy costs and non-neutral tax treatments were early considerations that modified MM • Equity reduces expected bankruptcy costs • Taxes favor debt financing • More recent explanations consider the incentive effects of capital structure, signaling, and the effects of changes in control rights

12. Incentives • Jensen and Meckling (1976) originated the incentive argument • Firms are run by self-interested agents, not pure profit maximizers • The separation of ownership (which implies claims on the profits) and control (management) gives rise to agency costs • There are agency costs with both equity and debt

13. Agency Costs of Equity • When outside equity is issued (equity not held by managers) it invites slack • Managers realize that if they waste a dollar, the outside owners will bear part of the cost • Thus, from a shirking point of view, the firm should be fully owned by management • However, this is not efficient because: • managers may want to diversify for risk spreading reasons • Financially constrained managers would have to use debt financing, which also has agency costs

14. Agency Costs of Debt • Debt and equity holders do not share the same investment objectives • A highly leveraged firm controlled by the equity holder will pursue riskier investment strategies than debt holders would like because of limited liability • Debt holders bear the burden if the firm goes bankrupt; the equity holders benefit only if the returns exceeds those necessary to pay off the debt

15. The Tradeoff • The optimal capital structure minimizes total agency costs: the debt-equity ratio should be set to equalize the marginal agency costs • Measurement problems are enormous • One qualitative prediction is that firms with substantial shirking problems will have little outside equity, while firms that can substantially alter the riskiness of the return will have little debt

16. Alternative Agency Explanations • Grossman and Hart (1982) provide a model where a manager with little or no stake in the firm controls the allocation of funds raised from the capital market • The manager decides how much to invest and how much to spend on himself; investment reduces the chance of bankruptcy • The manager does not want to spend all the funds on himself because if the firm goes bankrupt and he is fired he will lose quasi-rents • Since bankruptcy is associated with dismissal, the manager has to bear bankruptcy costs • Given this, debt financing can be an incentive device

17. Problems with Agency Explanations • Why should capital structure be used as an incentive instrument when the manager could be offered more explicit incentives that do not interfere with the capital structure choice? • Why can’t any incentive effect of a change in capital structure be undone by a change in the managerial incentive contract? • Without an answer to this question, the agency explanations do not really overturn MM • This problem is also true of signaling models

18. Signaling • Some models suggest that the debt-equity ratio signals information about the return distribution • Myers and Majluf (1984) argue that adverse selection poses problems for raising outside equity • Suppose the market is less informed about the value of the firm’s future cash flows than the manager of the firm and that there is no new investment to undertake • Then no new equity from new shareholders can be raised if the manager is acting in the interest of the old shareholders

19. Signaling • The manager will be willing to issue new shares only if they are overvalued (for example, if the shares are priced at 120 and the manager knows they are only worth 100) • Realizing this, no one will buy the new shares at the asking price • Realizing this, the manager will avoid issuing new shares unless debt is not a desirable alternative (for example, if there is so much debt that more might lead to financial distress)

20. Signaling • Suppose capital is needed for an investment • By the same reasoning, debt financing is generally preferred to equity financing • If equity financing must be used then the stock price will always decline in response to a new issue (this result has empirical support) because the manager’s private information that the current shares are overvalued is revealed • One way to see this is to note that if the share price were to increase with a new issue then it would always pay to raise equity irrespective of project value!

21. Control • The traditional explanations for capital structure ignore the fact that equity has voting rights; equity is not just a right to a residual return stream • Similarly, debt contracts typically include some contingent control rights • The distribution of control rights is important for incentive provision given that contracts are incomplete • A complete theory would explain why equity holders have voting rights and why debt contracts are linked to bankruptcy mechanisms

22. 3. The Separation of Ownership and Control • Most large firms are corporations controlled by managers who own little of the firm • Typical owners have little influence • The board of directors is supposed to monitor the management but evidence suggests that boards are rarely active • Further, the choice of directors is influenced more by managers than owners • Given this, what keeps managers from pursuing their own private goals?

23. Internal Discipline • Executive compensation plans often have incentive provisions: bonuses, stock, stock options, and other contingent compensation • Extensive theoretical and empirical work on executive compensation has been done • Further, directors are supposed to monitor managers • In practice, directors may lack adequate incentives; many have close ties to the managers • Following the publication of the handbook, there has been additional work on boards of directors and their roles in incentive provision and monitoring, but there is more work to be done

24. Labor Market and Product Market Discipline • Fama (1980) suggests that internal discipline is not as necessary as agency theory suggests because the managerial labor market provides discipline • A manager who does not maximize value will be punished by the labor market • Thus, reputational concerns provide incentives • Product markets may also discipline managers; this effect is likely to be stronger in more competitive markets • If the firm is a monopolist then there may be little incentive to avoid slacking off

25. Capital Market Discipline • Take-over threats also discipline managers • If managers do not maximize firm value, then there is a profit opportunity for someone to buy the firm and replace the managers with others who will

26. 4. Transaction Cost Economics The basic transaction cost economics strategy for deriving testable hypotheses is: Assign transactions (which differ in their attributes) to governance structures (the adaptive capacities and associated costs of which differ) in a transaction cost minimizing way Transaction cost economics relies more on comparative institutional analysis than notions of global optimums

27. Behavioral Assumptions • Friedman (1953) reflects the view of most economists: the realism of assumptions is not important; the usefulness of a theory depends on its implications • Williamson argues that assumptions are important; behavioral assumptions determine the set of feasible contracts, for example • Williamson describes “contracting man” as opposed to “rational man” • Contracting man is subject to bounded rationality and opportunism • Efforts to mislead, disguise, confuse are possible: these are difficult to incorporate into rational actor models

28. Incomplete Contracts Bounded rationality and opportunism imply: • All feasible contracts are incomplete Given this, structures that facilitate gapfilling, dispute settlement, adaptation, etc., are part of the problem of economic organization 2. Contracts are not guarantees Institutions that mitigate opportunism are important

29. The Role of Legal Enforcement • It is often assumed that property rights are well defined and that courts dispense justice at zero cost • In this view, parties follow contracts and when one party does not the other appeals to the courts • Llewellyn (1931) argued that contracts are more of “a framework highly adjustable, a framework which almost never accurately indicates real working relations, but which affords a rough indication around which such relations vary, an occasional guide in cases of doubt, and a norm of ultimate appeal when relations cease in fact to work” • Klein has followed up on this view of “relational contracts” • Recently, Baker, Gibbons, and Murphy have provided formal models using the theory of infinitely repeated games

30. Transactions • Generating testable implications from transaction cost economics requires that we describe features of transactions that affect transaction costs • According to Williamson, transactions differ along three dimensions: • The frequency with which they occur • The degree and type of uncertainty to which they are subject • Asset specificity • Asset specificity is the most critical attribute

31. Asset Specificity • Asset specificity refers to the degree to which an asset can be redeployed to alternative uses and by alternative users without sacrificing its productive value • Given that contracts are incomplete and contractual man is opportunistic, investments in relationship specific assets are discouraged • A simple dynamic model can illustrate the problem: initially parties agree on an ex post division of the surplus, then one party makes such an investment, then the other party may attempt to bargain for more favorable terms (incompleteness allows that this is possible) • Looking ahead, the investing party under-invests

32. Asset Specificity • Asset specificity can take many forms • Firm-specific human capital is one example • Untenured faculty members tend to under-invest in location-specific activities (serving on university committees, etc.) and emphasize investments that the market values (publications in refereed journals) • A faculty member who invests solely in location-specific activities is vulnerable to being exploited by his/her employer

33. Markets vs. Hierarchies According to Williamson, there are three main differences between market and internal organization: • Markets promote high-powered incentives and restrain bureaucratic distortions • Markets can sometimes aggregate demands to advantage, which allows for optimal scale and scope (a firm may not be able to achieve scale in an input itself, or sell the excess to its competitors) • Internal organization has access to distinctive governance instruments

34. Asset Specificity and Organization • Internal organization is favored when asset specificity is great • The specificity ensures that there are no separate demands to be aggregated • Integration overcomes the hold up problem • There are many other organizational implications of asset specificity and transaction costs

35. Another Implication: Second Sourcing • Buyers in the semiconductor industry have insisted that semiconductor producers license their design of chips to other manufacturers • This is an excessive requirement if concern for idiosyncratic disruptive events at the producer was the main issue – the producer could subcontract but retain control over total production • The buyers demand licensing because they are reluctant to specialize their product to a particular chip provided by a monopolist – they wish to avoid hold up

36. Capital Structure • Transaction cost economics emphasizes that the asset characteristics of investment projects matter, and that the governance structure properties of debt and equity are key attributes • The attributes of projects and the governance structure differences between debt and equity should be aligned in a discriminating way • When physical asset specificity is moderate, projects are easy to finance with debt • When asset specificity rises, the claims of debt holders afford only limited protection because the asset is not re-deployable • The benefits of closer oversight also grow when asset specificity rises • These effects make equity finance (which is more intrusive through the board of directors and through large shareholders) more beneficial

37. Data Problems • When pursuing transaction-cost arguments, it is quite easy to tell loose stories that seem reasonable • Recent research has emphasized that it is critical to dig deep into the data to formulate and evaluate transaction costs arguments • For example, Kenney and Klein (1983) attribute the practice of block booking of films to measurement problems: no one could forecast success, so distributors would make all or nothing arrangements with exhibitors • Recently, Hanssen questions this argument using evidence from real block booking contracts: exhibitors could exclude some films from the package

38. Data Problems • Klein, Crawford, and Alchian (1978) use GM-Fisher Body as an example of how relationship specific investments can lead to holdup and integration • Recently, Coase questioned their findings based on a more in-depth investigation of the relationship between GM and Fisher Body • Both block booking and GM Fisher Body have been the subject of recent debates in the literature • It is important to get the institutional details right before theorizing about them